SUYASH CHOUDHARY
The policy was along expected lines in terms of action with the MPC delivering a 50 bps hike, taking the repo rate to 5.90 per
cent. The recent dissent on stance continued from MPC member Prof Varma. However, there was a new development on one
dissent on quantum of hike. Dr Goyal voted for 35 bps hike only.
Before we turn to the important takeaways, here is one observation: if what one looks for is assured navigation in central
bankers, then Das is amongst the best we have ever had. Thus there is a clear recognition of our strengths and a sense of
confidence in the face of global challenges. However, the resolute normalisation of policy nevertheless continues without taking
the eye off the ball.
The clearest example of this, in our view, was in the clarification of stance given by the Governor today. As background, this
has been a somewhat vexing issue. Within the MPC itself there is one argument on appropriate stance linked to the level of
repo rate achieved and another around absorption of liquidity. The clarification from the Governor in some sense combined the
two. When the stance of monetary policy was moved from neutral to accommodative in June 2019, the repo rate was at 5.75
per cent; lower than what it is after the policy decision today. However, inflation was sub 4 per cent on near projections and
liquidity was mildly deficit. Today, near projections on inflation are still around 6 per cent and liquidity (when adjusted for very
high government balances part of which will be spent going ahead) is still in surplus. Hence both on ‘real' policy rate in the near
term as well as on current liquidity situation monetary policy is deemed to be more accommodative today. This definition,
alongside a refusal to get drawn into a debate on terminal policy rates, keeps monetary policy flexibility alive in the face of a
very hostile global situation. That said, for a variety of reasons, we believe that we are probably one policy meeting away from
achieving the terminal rate in this cycle. We discuss these below:
THE TERMINAL RATE
As noted above, it is prudent for the central bank to not get drawn into the terminal rate discussion at this stage. Governor
Das has commented, including in his speech today, on the difficulty in providing forward guidance in a policy tightening cycle,
especially one that is being conducted in such a highly uncertain environment. His observation that forward guidance may in
fact end up destabilising financial markets has been proven true even in recent experiences with developed market (DM)
central banks. Thus we have seen multiple examples on some of these having to go back within days on guidance provided on
quantum of upcoming rate adjustments, with consequent volatility in markets. That said, we expect the repo rate to peak at 6.15
– 6.25 per cent in this cycle with the final hike likely in the upcoming December policy. This is higher than our earlier expectation
of 6 per cent and reflects changes to DM rate forecasts by a very sharp extent lately, something that we weren't expecting
earlier (https://idfcmf.com/article/9551 ). This still means that we don't have to follow the US Fed lockstep, even as some
upward adjustment is prudent given the latest aggressive changes in Fed (and other DM central banks') terminal pricing lately.
We summarise below some of our reasons:
1. The anchor to our view has been that India's total fiscal and monetary accommodation over the past 2 years has been very
much more modest than many other economies. Not just that, monetary normalisation has been relatively quick and
proactive here as well. One aspect that doesn't get talked about enough when discussing monetary policy, is the central
bank's balance sheet. While these reductions are still at a nascent stage in DMs, RBI's balance sheet is already lower by
approximately 9 per cent over the past 11 months. Admittedly, a lot of this may be ‘forced' as the central bank's dollar asset
holding has been coming down as it has sold dollars to smoothen rupee movements. However, the effect on core liquidity is
the same and this has been shrinking progressively over the past few months. Local rate transmission is well and truly
underway, including into cost of loans courtesy the external benchmark linked loan regime that by now has significant
outstanding in the banking system.
2. The recent domestic growth acceleration has to be looked at in context: As of FY 22, we had barely crossed pre-pandemic
levels on real GDP, which itself was the culmination of some years of slowdown. Also, while the concurrent resilience in
domestic economic indicators is a source of great comfort, the global slowdown will take its toll via the export channel. Thus
it is highly unlikely that the current momentum on domestic growth continues, even as India's relative growth will still be
much better compared with much of the world.
3. As far as FY 24 CPI goes, we have only one ‘official' forecast from RBI: 5 per cent for Q1. However, the monetary policy report
reveals RBI staff estimates for the full FY 24. Assuming a normal monsoon, a progressive normalisation of supply chains, and no
further exogenous or policy shocks, structural model estimates indicate that inflation will average 5.2 per cent. If this holds true
going forward in the general thinking of MPC as well, then a 6.25 per cent terminal would yield a 100 bps real positive policy rate
on a forward looking basis. Given the context on growth as described above, this should be more than enough from a macro
stability and formation of inflation expectations standpoint.
4. The argument around hiking to ‘maintain' interest rate differentials vis-a-vis say the Fed has to be tread upon carefully. The
Fed, and for that matter some other DM central banks, are hiking because they have a run away inflation problem locally.
This in turn is owing to an irresponsibly large stimulus post the pandemic in these economies that caused severe local
imbalances. While RBI has to guard against the volatility that DM action is now bringing, managing these spill-overs can
manifest as somewhat tighter policy locally than otherwise would have been the case. This is already being captured, as an
example, in the Governor's interpretation of stance as detailed above. We have also moved our terminal rate expectation
higher to 6.15 – 6.25 per cent reflecting precisely this. However, we disagree about the usage of interest rates locally
beyond this: specifically as a tool to manage currency as some participants have argued. The channel via which this works
isn't as obvious when you don't have a very large domestic imbalance to offset.
5. Our Current Account Deficit (CAD) is an issue, but it is on account of two factors: One, the commodity shock emanating
from the Russia-Ukraine conflict was in effect a forced exporting of savings for a commodity importing nation such as India.
However, this shock is unwinding in a host of commodities and this should have a salutary effect on our CAD with a lag.
Two, for a variety of reasons India's near growth trajectory has become somewhat de-synchronised with many other nations
of the world (we are accelerating while many others are deaccelerating). This is also causing additional pressures on CAD.
As noted before, even with the growth acceleration our journey since the pandemic remains modest. In fact the decision to
be responsible in overall stimulus in response to the pandemic would have presumably been to ensure that the eventual growth
come-back would be more sustainable (this sits in stark contrast to many DMs who ‘purchased' growth from the future courtesy
unwieldy amounts of stimulus). If local monetary policy also became impatient and tamped down on this growth upturn, then
the whole advantage from the restrained stimulus earlier would not be availed of. Thus some amount of patience on CAD is
probably logical especially given the correction in commodities as noted here (Deputy Governor Patra noted RBI's expectation
of CAD coming off over second half of the year). If temporary measures are required eventually on currency they should rather
be administrative given this context.
PORTFOLIO STRATEGIES
There has been a resurgence in global market volatility over the past few weeks, with data and events triggering a
substantial repricing of terminal rates in many major DMs. This also translated locally in market repricing RBI rate trajectory
significantly higher. For instance, 1 year overnight indexed swap (OIS) yields have risen more than 50 bps since early
September. The bond curve has flattened aggressively, partly reflecting the above development. As an example, the yield
on 5 year and 10 year bonds virtually converged going into today's policy. We think this is excessive, and makes the relative
value in 3 – 5 years maturity government bonds all the more appealing. With a terminal overnight rate of around 6.25 per
cent, there is more than adequate cushion on 3-5 year rates and we expect the same to start to get factored into the shape
of the curve as market's peak rate expectations begin stabilising again over the next few months. Also very importantly, the
government borrowing calendar for second half of the financial year is quite light on supply in the 5 year segment when
compared with longer duration.
Finally, gross supply of state development loans (SDLs) will likely pick up meaningfully in H2 vs H1. This will alleviate some
of the ‘scarcity' in duration supply that has been plaguing longer term investors like PFs and insurers, and thereby help steepen
the curve somewhat as we go ahead.
Thus both reflecting the shape of the curve as well as our view on terminal policy rate, we continue to find the most value in 3 –
5 year government bonds. That said, shorter end rates have also repriced significantly thereby making money market products
relatively well placed provided the investment horizon here is kept somewhat longer than earlier accounting for the larger
volatility generally in markets in the current state of the world.
